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The Future of NAFTA: “Hecho en China”?

Presented at Laredo, Texas, and Monterrey, Mexico,
November 15-17, 2006.

My most recent “globalization moment” occurred the other day at
a department store in Northern Virginia where I live. I was sifting
through shirts on a rack when I noticed on the label the words,
“Hecho en China.” This was Lou Dobbs’ worst nightmare. Not only
were the shirts “Made in China,” but the labels also contained a
translation in Spanish! The label offers a fitting metaphor for my
subject today.

The rise of China is one of the great stories of our time, with
mostly positive implications for the countries of North America. My
subject today is what China’s rise means economically for the
United States, and what it means for Mexico. My message is that
Americans and Mexicans alike should not fear the economic rise of
China. China presents an opportunity, not a threat, to the NAFTA
partners. I’ll first examine impact of China’s rise on the U.S.
economy, then its impact on U.S.-Mexican trade, and explain in both
cases why fears are unfounded.

Much of the controversy focuses on China’s exchange rate, but
the real complaint is the rising competitiveness of China in a
broad range of sectors. Everyone can agree that imports stamped
“Made in China,” or “Hecho en China,” have soared in the
past decade. In 2005, imports from China reached $243.5 billion, a
huge increase from the $38.8 billion in goods imported from China
in 1994. During that same period, imports from China as a share of
total U.S. imports rose from 6 to 15 percent. Since 1994, imports
from China have grown more than twice as fast as imports from the
rest of the world.

Displacing other imports

A key to understanding our trade relationship with China is to
see China as the final assembly and export platform for a vast and
deepening East Asian manufacturing supply chain. Even in mid-range
products such as personal computers, telephones, and TVs, rising
imports from China have typically displaced imports from other
countries rather than domestic U.S. production. Final products that
Americans used to buy directly from Japan, South Korea, Taiwan,
Hong Kong, Singapore and Malaysia are increasingly being put
together in China with components from throughout the region.

China’s more economically advanced neighbors typically make the
most valuable components at home, ship them to China to be
assembled with lower-value-added components, and then export the
final product directly from China to the United States and other
destinations. As China imports more and more intermediate
components from the region, its growing bilateral trade surplus
with the United States has been accompanied by growing bilateral
deficits with its East Asian trading partners.

While imports from China have been growing rapidly compared to
overall imports, the relative size of imports from the rest of East
Asia has been in decline. In 1994, the year China fixed its
currency to the dollar, imports from East Asia accounted for 41
percent of total U.S. imports. Today imports from that part of the
world, including those from China, account for 34 percent of total
U.S. imports. In other words, the rising share of imports from
China has been more than offset by an even steeper fall in the
share of imports from the rest of Asia, as shown in Figure
3.[1]

The sharp rise in imports from China is not primarily driven by
China’s currency regime, but by its emergence as the final link in
an increasingly intricate East Asian manufacturing supply chain.
Benefits to U.S. Economy from Trade with China

While the critics of trade with China mistakenly focus on the
alleged harm it causes, they tend to overlook the benefits. Those
benefits include lower-priced imports for U.S. consumers and
businesses, expanding export opportunities to China, and the
economy-wide benefits of Chinese capital flowing to the United
States.

Imports from China allow Americans to stretch their paychecks
further, raising real wages for millions of workers. Money saved
because of lower prices for Chinese imports allows U.S. consumers
to spend more on other, non-Chinese goods and services, including
those produced in the United States. Those savings are especially
important for low- and middle-income American families who spend a
relatively larger share of their budgets on the discount-store
shoes, clothing and other products made in China.

American producers and workers have gained tremendously from
growing export opportunities to China. China’s fixed currency has
allegedly discouraged exports to China, but that is not supported
by the trade numbers. Since 2000, U.S. exports of goods to China
have increased by 158 percent, from $16.2 billion to $41.8 billion
in 2005. The rate of growth of U.S. exports to China since 2000 is
more than 12 times the rate of growth of U.S. exports to the rest
of the world other than China during the same period.[2] Our leading exports to China are soybeans,
cotton, and other agricultural products; plastics, chemicals, wood
pulp, and other industrial materials; civilian aircraft; and
semiconductors, computer accessories, industrial machines and other
machinery.[3]

The dollars earned by producers in China by selling in the U.S.
market are not stuffed under mattresses. They either come back to
the United States to buy our goods and services, or they are used
to invest in the United States through the purchase of U.S.-based
assets. The large majority of Chinese investment in the United
States comes through official purchases of U.S. Treasury bills by
China’s central bank. As of December 2005, Chinese monetary
authorities hold $262 billion in U.S. Treasury bills.[4]

China’s investment in the United States, while a relatively
small share of the total U.S. securities market, does put upward
pressure on bond prices and thus downward pressure on U.S. interest
rates. Lower rates, in turn, mean lower mortgage payments for
American families and lower borrowing costs for U.S. business.
Lower borrowing costs have also stoked demand for durable goods
such as cars and appliances, benefiting U.S.-based manufacturers.
And, of course, lower interest rates paid on U.S. Treasury bills
means less spending by the federal government and savings for U.S.
taxpayers.

A one-sided view of trade with China—a view that only considers
the alleged harm while ignoring the real benefits—will likely
result in misguided policies that would put those benefits in
jeopardy.

Impact of China’s rise on U.S.-Mexican
trade

Millions of Mexicans benefit everyday from trade with China for
all those very same reasons. The rise of China has delivered lower
prices and more choice for Mexican consumers, export opportunities
for Mexican producers, and more capital and lower interest rates
for households, companies and government.

Although all those blessing are real, China’s rise has had a
different impact on Mexico than it has on the United States.
Because China and Mexico are at a more similar stage of
development, their producers tend to compete head to head in a
broader range of products.

On a very simple level, China is bound to rise relative to
Mexico just because it is a much larger country. China’s population
is twelve times larger than Mexico’s, representing 20 percent of
the world’s population. Its growing presence in the U.S. economy is
not a negative reflection on Mexico, but of the simple fact that
China is reclaiming its rightful place in the global economy.

So it was not great shock when China surpassed Mexico in 2003 as
the number two supplier of imports to the U.S. market. As a market
for U.S. exports, Mexicans still buy two and a half times as many
American-made goods as do the Chinese, but that ratio is falling
rapidly and China will probably be buying more U.S.-made goods and
services than Mexico within a decade. And by my calculations—and
you heard it here first—sometime this fall China surpassed Mexico
as America’s number two trading partner in terms of two-way goods
trade, behind only Canada. The most politically sensitive of those
measures for Mexico is its competitiveness in the U.S. import
market. Mexico’s share of U.S. imports has gone through two
transitions in the past two decades. The first occurred in 1994
when Mexico joined the North American Free Trade Agreement.

As the chart shows, Mexico’s share of total U.S. goods imports
began to rise sharply at that point, rising sharply from 6.7
percent in 1993 to 11.8 percent in 2002. But starting in 2003,
Mexico actually began to lose market share, bottoming out at a low
point of 10.2 percent in 2005 before it began to recover in
2006.

One obvious cause was the economic slowdown in the United
States, which curbed demand for imports from Mexico, in particular
vehicles, auto parts and heavy machinery. But another cause was
clearly China’s growing success in the U.S. market, in particular
its rapid expansion of apparel and other labor-intensive
manufacturing imports. As the figure also shows, Mexico’s market
share began to dip just as China entered the WTO and began to ramp
up its imports to the United States.

The story is more complex than Chinese products simply replacing
Mexican products in the U.S. market. Mexico’s comparative advantage
has been shifting relative to China. Mexican producers have
continued to enjoy a strong comparative advantage in petroleum
products, food and beverages, passenger cars and parts, and
industrial machinery. In each of those product categories, Mexico
has expanded its exports to the United States alongside increasing
imports to the United States from China. With the sharply increased
price of oil in recent years, U.S. imports of Mexican petroleum
products soared by $15.7 billion from 2001 to 2005. The huge
increase in America’s oil bill from Mexico has probably had the
effect of keeping the peso strong relative to the U.S. dollar and
thus partially crowding out non-petroleum imports from Mexico.

Mexican and Chinese producers both appear to enjoy comparative
advantage in such mid-range products as telecommunications
equipment and TVs, radios and other audio-visual equipment.
Producers in both countries have seen significant increases in
their exports to the United States in those products since
2001.

Producers in China are clearly cutting into Mexico’s market
share in several important manufacturing sectors. The most obvious
is textiles and apparel. When China entered the WTO in 2001, it
immediately benefited from the ten-year phase out of global quotas
on textile and apparel trade. From 2001 to 2005, China’s apparel
and footwear imports to the United States rose by $18.9 billion
while Mexico’s imports to the United States fell by $1.8 billion.
Textile and apparel employment in maquiladora factories fell by
more than 100,000. Even after the post-China WTO decline, the
Mexican textile and apparel sector still employs more workers than
it did before NAFTA.

Chinese producers also expanded their market share at the
expense of Mexican producers in computers, parts and peripherals,
expanding imports to the U.S. by $30.9 billion while Mexican
imports fell by $3.6 billion; and toys, sporting goods and
bicycles, where Chinese imports also grew sharply while Mexican
imports to the United States declined. Chinese producers also
dramatically increased their imports to the United States of
furniture, appliances and household goods, while imports from
Mexico increased only slightly.

Mexicans should not mourn the relative decline of the country’s
textile and apparel industries. The growth in those industries in
the years immediately after NAFTA was an artificial phenomenon. It
was a textbook example of “trade diversion,” which allowed Mexican
producers to supplant more efficient producers outside of NAFTA
because of its tariff-free access to the U.S. market. As global
quotas on textile and apparel trade were dismantled, Mexico’s
artificial advantage diminished. The coup de grace was China’s
entry into the WTO in 2001 and its full participation in the more
open and non-discriminatory global trading system.

The result has not been an overall decline in Mexico’s export
competitiveness and industrial output. Like the United States,
Mexico has seen a shift in the nature of its output in response to
China’s rise, with further specialization in those products in
which Mexico enjoys its strongest comparative advantage. Overall
employment in the maquiladoras has not suffered long-term decline
in the face of rising competition from China, but rather a change
in the mix of jobs. Since 2003, employment has been rising overall,
from 1,042,085 to 1,213,841 in 2006.

As the chart shows, employment has been rising in chemicals,
services, electronics, machinery, furniture, and transportation.
The exception is textiles and apparel, for all the reasons we just
discussed. As a recent report by the Dallas Fed concluded,
“Mexico’s export industries will continue to benefit from being on
the doorstep of the greatest consumer market on earth. But for
textiles and apparel, NAFTA isn’t what I used to be.”[5]

Mexico’s Three Advantages over China

Mexicans enjoy three important advantages in competition with
Chinese producers. One is proximity, or as those in the real estate
business would say, “Location, location, location!” A previous
Mexican president once lamented that it was part of Mexico’s burden
as a nation to be “so far from God and so close to the United
States.” I’ll leave it to others to ponder Mexico’s relationship to
God, but in more earthly terms of trade and economic growth, it is
clearly in Mexico’s advantage to share a 2,000-mile border with the
world’s largest and most advanced economy. Proximity means that
Mexico can become a key supplier in an integrated supply chain that
values “just-in-time” delivery. Delivery by truck and rail through
Laredo and other ports of entry can mean goods can be delivered in
just a few days compared to the three-week delivery time typical of
shipments from China. This is especially advantageous with heavier
goods such as machinery or auto parts in which shipping costs are
higher. It also means that companies can ship goods between
affiliates far more easily, quickly, and cost effectively.

The second advantage is the North American Free Trade Agreement.
More than 12 years after its implementation, the NAFTA has
succeeded by any objective measure. It has stimulated a sizeable
increase in U.S.-Mexican trade and helped to institutionalize
Mexico’s economic reform and modernization. Despite a few loose
ends, such as trucking and sugar, our two economies have
essentially achieved the goal of free trade. And although U.S.
trade barriers are quite low in general for imports from the rest
of the world, some of the U.S. government’s highest remaining
barriers apply to sectors where China enjoys its strongest
comparative advantage, such as lower end, labor-intensive consumer
products such as apparel, footwear, toys, and sporting goods.

As a result of those first two advantages, the Mexican and
American economies are far more deeply integrated than the Chinese
and American economies. For Americans, China is the big-box
retailer on the edge of town, while Mexico is our next door
neighbor and business partner.

While China has been storming ahead to dominate goods trade,
Mexico’s commercial ties to the United States surpass China’s ties
by almost every other measure. In services, Mexico’s two-way trade
with the United States totaled $35.3 billion in 2005 compared to
$15.6 billion in China-U.S. trade.[6]
American-owned affiliates in Mexico sold more than twice as much in
the Mexican market in 2004 as did American-owned affiliates in
China. American companies employ more than twice as many workers in
Mexico as they do in China.

The story is the same with foreign direct investment. As of the
end of 2005, American firms owned $71 billion of foreign direct
investment in Mexico compared to $17 billion in China. From 2001
through 2005, U.S. firms channeled $39 billion in FDI to Mexico
compared to $9 billion to China. Mexican firms own $8.6 billion in
FDI in the United States compared to $0.5 billion owned by Chinese
firms in the United States. Propelled by all this cross-border
investment, U.S.-Mexican trade flows are far more likely to be
intra-firm trade than U.S.-China trade. Some 30 percent of
U.S.-Mexican goods trade occurred between affiliates of the same
company in 2003, compared to less than 1 percent of U.S.-China
trade.

As for labor-market integration, there is no comparison. The
number of Mexican-born people living in the United States dwarfs
the number of Chinese-born. Since 1990, 3.80 million Mexicans have
immigrated legally to the United States compared to 642,000
Chinese. Since 2000, the number of Mexicans entering the United
States each year on temporary, non-immigrant visas has averaged
4.36 million compared to 481,000 Chinese. Mexicans have the edge in
virtually every visa category—pleasure, business, and temporary
workers, including highly skilled H1-B workers. Mexican workers in
the United States send home an estimated $20 billion a year in
remittances, far greater than the amount remitted by Chinese
workers in the United States. Compared to other inflows, those
remittances are stable and countercyclical.

Mexico’s third, and profoundly important advantage, is its
maturing democratic system. Mexico’s recent election was a
difficult test of that system, and the system worked. Although
democracy can be messy, as we’ve seen in both our countries, it is
ultimately more stable and transparent than authoritarian systems.
Public frustrations with policy can be addressed through elections
and incremental change rather than through confrontations and
violence.

At the end of the day, nations do not compete with one another
in some kind of zero-sum sporting contest. China’s gains do not
necessarily translate into Mexico’s losses. The two countries can
prosper together. The key to Mexico’s continued growth and
development does not lie in Beijing or in Washington but within
Mexico itself. My advice to our friends in Mexico is that same as
the advice I give, free of charge, to the U.S. government. Our
focus should be on free trade and free-market reforms at home, not
on complaints about our foreign trading partners.

[4] Timothy D. Adams, Undersecretary of the U.S.
Treasury for International Affairs, Testimony before the Senate
Finance Committee, Hearings on “U.S.-China Economic Relations
Revisited,” March 29, 2006.